Answers to Exercise Chapter 8

Answer Exercise 1

List price (after trade discount) Installation costs Pre-production testing

$000 90 18 10 118

Answer Exercise 2

Only those costs which are directly attributable to bringing the asset into working condition for its intended use should be included administration and other general overhead costs cannot be included . Costs included should only be normal, not abnormal, costs. Total $000 250,000 5,000 10,000 18,000 100,000 150,000 20,000 30,000 583,000 Exclude $000 Include $000 250,000 5,000 10,000 18,000 75,000 141,000 20,000 519,000

Purchase price of land Stamp duty Legal fees Site preparation and clearance Material (Note 1) Labour (150,000 9,000) (Note 2) Architects fees General overheads

25,000 9,000 30,000 64,000

Notes: 1. The costs of spoiled material and faulty design are abnormal costs. 2. The $9 million labour cost incurred during the period of the stoppage is an abnormal cost and is excluded. Answer Exercise 3
(a)(i) Property, plant and equipment are tangible assets that are held by an enterprise for use in the production or supply of goods or services, for rental to others, or for administrative purposes and are expected to be used during more than one period.

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An item of property, plant and equipment should be recognised as an asset when it is probable that future economic benefits associated with the asset will flow to the enterprise, and the cost of the asset to the enterprise can be measured reliably. (a(ii) The initial cost of an item of property, plant and equipment comprises its purchase price and any other costs directly attributable to bringing the asset to working condition for its intended use. The purchase price is taken after deduction of any trade discounts or rebates (but not early settlement discounts), but includes import duties and non-refundable purchase taxes. Directly attributable costs are the incremental costs that would have been avoided had the assets not been acquired. These costs include: The cost of site preparation; Initial delivery and handling costs; Installation costs; Professional fees such as those of lawyers, architects and engineers; and The estimated cost of dismantling and removing assets and restoring the site, to the extent that such costs represent a present obligation of the reporting enterprise. In the case of a self-constructed asset, the cost is determined using the same principles as for an acquired asset. Cost is measured as the production cost of the asset, which consists of the purchase price of the raw materials and consumables used, plus other costs incurred that are directly attributable to the production of asset. In addition, the production cost of the asset may include a reasonable allocation of production overheads and interest on capital borrowed to finance the production of the asset to the extent that is accrues in respect of the period of production. However, the cost of abnormal amounts of wasted material, labour or other resources incurred in the production should not be included. (b)(i) Initial cost of the addition to the plant $ Basic list price Trade discount Shipping and handling costs 420,000 (63,000) 4,500

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Installation costs Pre-production testing Site preparation cost Electrical cable installation (21,000 9,500) Concrete reinforcement Own labour costs Dismantling and restoration costs (20,000 + 5,000) Initial cost of the addition to the plant

10,000 12,500 11,500 6,250 11,250 25,000 438,000

The early settlement discount and the maintenance cost are revenue items. The sales tax on the plant can be reclaimed by Hanford. The cost of the specification error must be charged to the income statement. (b)(ii) Accumulated depreciation on the plant disposed of: The accumulated depreciation on the plant disposed of is calculated as 10% of $300,000 for three years = $90,000. (b)(iii) Hanford Ltd Corrected schedule of the movement on plant Cost $ Balance at 1 Jan 2001 Additions at cost Disposals Depreciation charge for the year (W1) Balance at 31 Dec 2001 Working: (W1) Depreciation charge for the year Depreciation charge for the year is 10% of the corrected cost of plant at the year end, i.e. 10% x $1,762,000 = $176,200. 1,762,000 1,624,000 438,000 (300,000) (90,000) 176,200 736,200 Depreciation $ 650,000

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Answer Exercise 4

(a) (b)

(c)

This expenditure enhances the economic benefits of the machine by increasing its productivity and therefore would be capitalized subsequent expenditure. It would be difficult to argue that the replacement of the windows enhanced the economic benefits of the head office and therefore this would be treated as revenue expenditure and written off to the statement of comprehensive income as incurred. The engine of an aircraft is likely to be a separate component asset of the aircraft as its economic life will be substantially less than that of the aircraft itself. The engine will be depreciated over a five year period and the cost of the replacement engine will then be capitalized every five years.

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Examination Style Questions Answer 1 (a)(i) HKAS 16 states that an item of property which qualifies for recognition as an asset must initially be measured at cost. Cost comprises the following components. (1) Purchase price, less any trade discounts or rebates, but not settlement discounts (2) Import duties and non-refundable purchase taxes (3) Directly attributable costs of bringing the asset to working condition for its intended use. These include the cost of site preparation, initial delivery and handling costs, installation costs and professional fees. Also included is the estimated cost of removing the asset and restoring the site, to the extent that it is recognised as a provision under HKAS 37 Provisions, contingent liabilities and contingent assets. Certain costs will not normally be part of the cost of property, plant and equipment, and must instead be expensed. These are administration costs, start-up costs and initial operating losses. In the case of self-constructed assets, the principles are the same as for acquired assets. This may include labour costs of the entity's own employees. Abnormal costs such as wastage and errors are excluded. In addition to HKAS 16 and HKAS 37 we also need to consider HKAS 20 on government grants which states that the cost of an asset may be reduced by any such grants. (a)(ii) There may be subsequent expenditure on an item of property, plant or equipment, after its purchase and recognition. Such expenditure may be added to the carrying amount of the asset, but only when the original criteria are met. All other subsequent expenditure is recognised as an expense as it is incurred. The standard gives examples of the kind of improvements that would allow subsequent expenditure to be capitalised. (1) Modification of an item of plant to extend its useful life (2) Upgrade of machine parts to improve the quality of output (3) Adoption of a new production process, leading to large reductions in operating
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costs (b) HKAS 16 allows property, plant and equipment (most commonly property) to be shown at a revalued amount. Such revaluations are permitted under the allowed alternative treatment rules providing that the fair value of the asset can be measured reliably. However, revaluation, particularly of property has been open to abuse, with companies 'cherry picking' those properties whose valuation is favourable to show at valuation. Accordingly, HKAS 16 tries to bring some consistency to the practice of revaluation. When an item of property, plant and equipment is revalued, the whole class of assets to which it belongs should be revalued. All the items within a class should be revalued at the same time to prevent selective revaluation of certain assets and to avoid disclosing a mixture of costs and values from different dates in the financial statements. Revaluations must be sufficiently regular, so that the carrying value of an asset does not differ significantly from its market value. In addition, revaluations must be kept up to date. Surpluses and deficits In the case of a surplus, HKAS 16 requires the increase to be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus. The exception is when the increase is reversing a previous decrease which was recognised as an expense. Then it is treated as income. The treatment is similar for a decrease in value on revaluation. Any decrease should be recognised as an expense, except where it offsets a previous increase taken as a revaluation surplus. In this case the decrease will be recognised in other comprehensive income reducing the balance on the revaluation surplus. Any decrease greater than the previous upwards increase in value must be taken as an expense in the income statement section of the statement of comprehensive income. Gains and losses on disposal Gains or losses are the difference between the estimated net disposal proceeds and the carrying amount of the asset. They should be recognised as income or expense in the income statement. Any revaluation surplus standing to the credit of a disposed asset should be transferred to retained earnings as a reserve movement.

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(c)(i) Following HKAS 16, not all the components of the cost of the item of plant may be capitalised. While trade discounts may be capitalised, settlement discounts may not. Such discounts are a revenue item and will probably be deducted from administration costs in the income statement. Likewise, maintenance is a revenue item. There will be a prepayment in the statement of financial position for maintenance costs relating to subsequent years. The cost of the error in specifying the power loading is an abnormal cost and must be charged to the income statement. The costs to be capitalised may now be calculated as follows.

(c)(ii) BROADOAK INCOME STATEMENT (EXTRACT) FOR THE YEAR TO 30 SEPTEMBER

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Answer 2 The cruise ship is an example of what can be called a complex asset. This is a single asset that should be treated as if it was a collection of separate assets, each of which may require a different depreciation method/life. In this case the question identifies three components to the cruise ship. The carrying amount of the asset at 30 September 2004 (eight years after acquisition) would be:

Ships fabric This is the most straightforward component. It is being depreciated over a 25 year life and depreciation of $12 million (300/25 years) would be required in the year ended 30 September 2005. The repainting of the ships fabric does not meet the recognition
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criteria of an asset and should be treated as repairs and maintenance. Cabins and entertainment area and fittings During the year these have had a limited upgrade at a cost of $60 million. This has extended the remaining useful life from four to five years. The costs of the upgrade meet the criteria for recognition as an asset. The original fittings have not been replaced thus the additional $60 million would be added to the cost of the fittings and the new carrying amount of $110 million will be depreciated over the remaining life of five years to give a charge for the year of $22 million. Propulsion system This has been replaced by a new system so the carrying value of the system ($25 million) must be written off and depreciation of the new system for the year ended 30 September 2005 (based on use) would be $14 million (140 million/50,000 x 5,000).

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Answer 3

The depreciable amount is $900,000 (920,000 20,000 residual value) and, based on an estimated machine life of 6,000 hours, this gives depreciation of $150 per machine hour. Therefore depreciation for the year ended 30 September 2006 is $180,000 ($150 x 1,200 hours) and for the year ended 30 September 2007 is $270,000 ($150 x 1,800 hours). Note: early settlement discount, staff training in use of machine and maintenance are all revenue items and cannot be part of capitalised costs.

The revised depreciable amount is $630,000 (670,000 40,000 residual value) and with a revised remaining life of 4,500 hours, this gives a depreciation charge of $140 per machine hour. Therefore depreciation for the year ended 30 September 2008 is $119,000 ($140 x 850 hours).
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Answer 4

Workings (figures in brackets in $000) (i) The exterior of the aircraft is depreciated at $6 million per annum (120,000/20 years). The cabin is depreciated at $5 million per annum (25,000/5 years). The engines would be depreciated by $500 ($18 million/36,000 hours) i.e. $250 each, per flying hour.

(ii)

Cabin fittings at 1 October 2008 the carrying amount of the cabin fittings is $75 million (10,000 2,500). The cost of improving the cabin facilities of $45 million should be capitalised as it led to enhanced future economic benefits in the form of substantially higher fares. The cabin fittings would then have a

carrying amount of $12 million (7,500 + 4,500) and an unchanged remaining life of 18 months. Thus depreciation for the six months to 31 March 2009 is $4 million (12,000 x 6/18). (iii) Engines before the accident the engines (in combination) were being depreciated at a rate of $500 per flying hour. At the date of the accident each engine had a carrying amount of $6 million ((12,600 600)/2). This represents
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the loss on disposal of the written off engine. The repaired engines remaining life was reduced to 15,000 hours. Thus future depreciation on the repaired engine will be $400 per flying hour, resulting in a depreciation charge of $400,000 for the six months to 31 March 2009. The new engine with a cost of $108 million and a life of 36,000 hours will be depreciated by $300 per flying hour, resulting in a depreciation charge of $300,000 for the six months to 31 March 2009. Summarising both engines:

Note: marks are awarded for clear calculations rather than for detailed explanations. Full explanations are given for tutorial purposes.

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